7.1 derivative instruments and deriative market features Flashcards
A derivative
a financial instrument that derives its performance from an underlying asset (referred to as the underlying)
Derivative instruments
contracts between counterparties, at least one of which is usually a financial intermediary.
derivative contract
has a specified maturity, which is the time between when the contract is initiated and the settlement date.
Other key features of derivatives include:
Contracts can be structured as forward commitments (e.g., forwards, futures, and swaps) or contingent claims (e.g., options).
Derivatives can be used to pursue strategies (e.g., short positions) that would be more difficult to execute in the cash market.
Index-based derivatives can help investors quickly and easily diversify their portfolios.
Large exposures can be achieved with relatively small cash outlays.
Transaction costs are typically lower and liquidity is generally higher compared to trading underlying assets in the spot market.
Derivatives are critical to the risk management process because they can be used to adjust, hedge, or eliminate exposure to certain risks.
It is difficult to create derivatives on bonds because
most issuers have more than one issue outstanding.
Fixed-income derivatives are typically written to allow multiple bonds to be used for settlemen
Stand-alone derivatives
are distinct contracts, are traded on public exchanges or in over-the-counter (OTC) markets.
Embedded derivatives
part of other assets, such as callable bonds, and cannot be traded separately in derivatives markets.
OTC derivative markets
driven by dealers, also known as market makers, which are typically financial intermediaries (e.g., banks)
Market participants, such as investors and companies, are seeking to hedge their risks or to take speculative positions and dealers are willing to act as counterparties.
As a result of these transactions, dealers become exposed to various risks, which they typically hedge by entering into offsetting transactions with other dealers in the OTC market.
Exchange-traded derivatives
include futures, options, and other contracts that are available to be bought and sold on public markets
Unlike OTC derivatives, these contracts have standardized terms with respect to matters such as contract size, delivery method, definition of the underlying, and maturity date.
ETD markets are also highly transparent, with details of all trades being recorded by exchanges and disclosed to regulators.
Because of this standardization and transparency, exchange-traded contracts tend to be more liquid than OTC derivatives.
Exchange-traded derivatives are used for hedging purposes, particularly by producers and users of commodities, but there are also speculators who use these markets to take positions based on their expectations of price movements.
characterized by efficient clearing and settlement operations
clearing
the process of verifying the identities of counterparties and confirming trade execution
settlement
refers to ensuring that final payments are made and delivery terms are met
ETD markets can be compared to OTC markets based on the following key characteristics:
Liquidity: Typically higher for ETD markets
Trading costs: Lower for ETD markets
Transparency: Greater for ETD markets
Standardization: Higher for ETD markets
Flexibility/Customization: Lower for ETD markets
Counterparty credit risk: Lower for ETD markets due to margin requirements
The central clearing process for interest rate swaps, which is also used for other OTC derivatives, involves three steps:
Step 1: Two parties (typically financial intermediaries) reach a swap agreement through a swap execution facility (SEF), which is an online trading platform used by dealers.
Step 2: The details of the SEF transaction are submitted to the CCP.
Step 3: The CCP replaces the existing trade and enters into two separate swaps with each of the parties based on the terms of their agreement. This step, known as the novation process eliminates bilateral credit risk by having the CCP act as the counterparty to each of the parties to the original transaction. The CCP also provides clearing and settlement services.
Which of these is best classified as a forward commitment?
a) A convertible bond
b) A call option
c) A swap agreement
c) A swap agreement
A swap agreement is equivalent to a series of forward agreements, which can be described as forward commitments.
In contrast to over-the-counter options, futures contracts most likely:
a) are not exposed to default risk.
b) represent a right rather than a commitment.
c) are private, customized transactions.
a) are not exposed to default risk.
Over-the-counter options are exposed to default risk, but futures contracts are standardized transactions that take place on futures exchanges and are not exposed to default risk.
